BONDS
As investors were anticipating a Fed rate hike and a strong employment report for June, bond yields had risen. Yields were already heading down following the rate hike on June 30 and picked up speed following the weaker-than-expected employment report. Yields then stabilized until this week when bond investors were nervously anticipating inflation news. While the PPI news was also friendly, the bond market didn't rally until Friday morning's CPI report. Inflation news was sanguine - and certainly better than expected by market players. Friday's 2-year note yield closed at its lowest level since the end of May and the 10-year note yield closed at its lowest level since mid-April.

Since 30-year conventional fixed rate mortgage loans are tied to the 10-year note yield, we may see a drop in mortgage rates this week. This will certainly open the floodgates for late bloomers in the housing market for both refinancing and home purchases.

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

Inflation at the forefront
Inflation news was relatively benign in June as three key measures came in below expectations. Energy prices managed to post declines in the import price index and the PPI for finished goods, but rose again in the CPI. Excluding food and energy, prices moderated in both the PPI and the CPI on a monthly basis. On a year-over-year basis, the core CPI was about unchanged (after rounding) for the third straight month, but the core PPI accelerated for the third straight month. Import prices excluding petroleum also moderated on a year-over-year basis. (The core import price index here excludes oil, but not food prices; the CPI and PPI exclude both food and energy prices.)

Since the import price index only covers tradable goods, this index shows greater price volatility than the PPI, which primarily covers prices of domestically produced goods, and the CPI, which includes prices of services as well as goods. The PPI has always fluctuated more dramatically than the CPI because of the latter's greater emphasis on services. As we have mentioned before, prices of services do not vary as rapidly as goods prices. The discrepancy between producer price inflation and consumer price inflation has narrowed. If the expansion continues unabated, the core PPI will soon start rising more rapidly than the core CPI as increased demand for goods will lift prices. In contrast, the CPI will be held in check by slower price gains in the service group.

June retail sales tumble
Retail sales fell 1.1 percent in June after an upward revised gain of 1.4 percent in May. Excluding the volatile auto sector (which posted a 4.3 percent drop in June), retail sales dipped 0.2 percent after an upward revised gain of 0.9 percent in May. While furniture & home furnishings managed a 1.1 percent hike and electronics & appliance stores posted a 0.5 percent gain in June, a good number of key categories decreased during the month, including food & beverage, gas stations, clothing & accessory stores, general merchandise and miscellaneous store retailers.

While the June figures were less than ideal, retail sales still managed to grow at a 5.8 percent rate in the second quarter, although this was almost half the 9.7 percent rate growth pace recorded in the first quarter. Excluding auto and gasoline stations, retail sales grew at a 5.5 percent rate in the second quarter, down from a 10.3 percent rate in the first quarter. It appears as though consumers are following the same trend exhibited in the second half of 2003 when sales surged in the third quarter but moderated in the fourth quarter. Keep in mind that a 10 percent pace is simply unsustainable in the long run when it isn't matched by an equal rise in disposable income. Nominal disposable income was rising at less than a 6 percent rate in the second quarter (with only two of the three months of data available) after growing at an 8.3 percent rate in the first quarter of the year.

It is really too soon to tell whether June's soggy retail sales figures are revealing a new trend, or whether consumers were taking a pause that refreshes. However, if July sales are equally sluggish, concern will grow about the lack of growth in the consumer sector. Keep in mind, though, that the consumer sector does not need to be the engine of growth in this phase of the business cycle. One would expect capital spending to start accelerating at this point.

June production dips
The index of industrial production fell 0.3 percent in June after posting healthy gains in the two previous months (0.8 and 0.9 percent respectively). Among major market groups, business equipment production rose 0.4 percent, about one-fifth as fast as the previous month, but an increase nevertheless. Consumer goods production decreased, as did materials. Nonindustrial supplies (of which construction is a subset) also declined 0.4 percent for the month. Mining edged up 0.1 percent but utilities dropped 2.3 percent. After all was said and done, the index of industrial production still managed to grow at a 5.8 percent rate in the second quarter, only marginally slower than the first quarter's pace of 6.7 percent. The growth in production over the past four quarters has helped to lift the capacity utilization rate to 77.3 in the second quarter, its highest quarterly level since the second quarter of 2001. On the plus side, this rate is not anywhere near where it would begin signaling supply bottlenecks and inflationary pressures. On the minus side, it isn't rising rapidly enough to suggest that capital spending on plant and equipment will need to step up a notch.

Two key manufacturing surveys from the Philadelphia Federal Reserve Bank and the New York Federal Reserve Bank continued their upward climb in July. This bodes well for industrial production. Most of the time, increases in these two indexes point to increases in industrial production.

Trade deficit narrows in May!
The international trade deficit narrowed to $46 billion in May after reaching a $48.1 billion shortfall in April. Exports jumped 2.9 percent during the month while imports managed a meager 0.4 percent gain for the second straight month. Nonauto capital goods exports posted a healthy gain, helping to lift the total. On the import side, oil imports were roughly unchanged and imports of nonauto consumer goods fell outright. As a result, export growth has surpassed import growth on a year-over-year basis for three straight months. Yet, since total imports are roughly 50 percent higher than total exports, the trade deficit remains wide by historical standards.

Although the May trade deficit narrowed, the April-May average still is well above the first quarter average. Consequently, the foreign sector will continue to act as a drag on GDP growth in the second quarter.

Budget red ink deepens
The U.S. Treasury announced a small budget surplus of $19.1 billion for the month of June. Budget data are not adjusted for seasonal variation, and June typically sees a significant surplus due to additional tax receipts from estimated individual and corporate tax payments. The June surplus was the smallest for this month since fiscal year 1995. For the fiscal year-to-date, the budget deficit is $326.6 billion compared with a $269.7 billion shortfall last year for the same 9-month period. While total receipts have increased 3.5 percent from a year ago, total outlays are up 6.4 percent. As long as the budget gap deteriorates further, the U.S. Treasury will be increasing the supply of Treasury securities. At this time, safe haven status has helped keep Treasury yields relatively low, but a steadily increasing supply of securities will eventually lead to rising Treasury yields.

The Bottom Line
Inflation was the focus of the week as market players worried whether or not the PPI and CPI would accelerate in June: indeed they did not. Both were either in line with expectations or softer than expected. Inflation will remain a key focus in the market place in coming months, but perhaps, market players will not be as worried as they were this past week.

Industrial production and retail sales both fell in June but managed to post a healthy growth rate for the second quarter. Key Fed manufacturing surveys point to improved industrial production in July, but the jury is still out on retail sales. Will consumers go out in full force in July'

Most economists are looking for slightly slower GDP growth in the second quarter relative to the first. The question is, will economic activity slow down significantly in the second half of the year, or will it remain steady' A sharp slowdown could forestall planned Fed rate hikes, but relatively steady growth with moderate inflation will keep the Fed on a "measured" upward path.

Speaking of Fed rate hikes, market players will be on pins and needles as they wait for Fed Chairman Alan Greenspan's monetary report to Congress on Tuesday afternoon and Wednesday morning.

Looking Ahead: Week of July 19 to July 23

Tuesday
Housing starts decreased 0.7 percent in May to a 1.97 million-unit rate after recording a modest 0.9 percent drop in April. Despite these small declines in the past two months, there is no question that overall housing activity remains robust. It remains to be seen whether rising mortgage rates will take a big bite out of housing construction in the next few months.

Housing starts Consensus Forecast for June 04: 1.98 million-unit rate
Range: 1.87 to 2.02 million-unit rate

Housing permits Consensus Forecast for June 04: NA
Range: NA

Federal Reserve Chairman Alan Greenspan is scheduled to present the second monetary policy report to Congress (the first was delivered in February). He addresses the Senate Banking Committee at 2:30 p.m. ET. Market players will nervously be watching whether or not the Fed chairman will reveal any new thoughts on the inflation outlook or the pace at which interest rates will be increased in upcoming months.

Wednesday
Federal Reserve Chairman Alan Greenspan is scheduled to present the second half of his second monetary policy report to Congress (the first was delivered in February). He addresses the House Financial Services Committee at 10:00 AM. Usually, the delivery on the second day is identical to the first, unless the Fed chairman believes that the financial markets misinterpreted him. The Q&A may also yield different comments.

Thursday
New jobless claims increased 40,000 in the week ended July 10 to 349,000, bringing the 4-week moving average up to 339,000. The annual auto-retooling shutdown took place in a different week than usual, affecting the seasonal adjustment process. Three times over the past four weeks, new jobless claims have run 349,000.

Jobless Claims Consensus Forecast for 7/17/04: 355,000 (6,000)
Range: 340,000 to 375,000

The index of leading indicators rose 0.5 percent in May. Perhaps the same rise will not be likely in June. Among the indicators that have already been reported, the factory workweek and vendor performance are down while jobless claims are up, all negative for the index. The 10-year note to fed funds rate spread is down also. Stock prices and consumer expectations rose in June.